The rising cost of VAT fraud has forced its way onto the agendas of Europe’s highest levels of government. This final instalment considers the solution that the German Presidency is pushing and argues that this “solution” may cause as many problems as it fixes.

There is an old aphorism, “under capitalism man exploits man; under communism this is completely reversed,” that captures the problems inherent in German proposal for solving Europe’s VAT fraud problem – the so-called ‘reverse charge’ system. The details, as you will have come to expect, seem complex. The reverse charge system, however, is easy in principle; it turns the current VAT system into a sales tax system.

Reverse-Charge

The name ‘reverse-charge’ makes perfect sense to people with a full mastery of the current VAT system. Recall that, under the current VAT system, it is the sellers who collect the VAT from their buyers, and turn over the receipts to the tax authorities after deducting the VAT they paid on things they bought from their own suppliers.

Under the reverse-charge system, it is the buyer who is responsible for paying the VAT and turning over the receipts. However – and here is a key difference – the buyer can reduce the amount that must be turned over to the government to the extent that he passes the VAT obligation to his customers with a ‘reverse-charge’. Thus a firm that buys its inputs from firms and sells all its output to firms pays no VAT as long as the value of its sales exceeds the value of its inputs. In this way, the VAT obligation gets pushed all the way down the value-added chain, from buyer to buyer right to the point of final sale to consumers. That’s why it is equivalent to a sales tax system (apart from all the record-keeping that suppliers must do to avoid paying VAT).

Conceptually, it is worth noting that this is just the VIVAT system with a zero common VAT rate.

If cross-border fraud were the only concern, the reverse-charge system would eliminate the problem. Reverse-charge eliminates all three of the ABCs of the VAT fraud for business-to-business transactions since businesses collect no VAT on B2B dealings. The only firm to collect VAT on the behalf of the government is the retail store that sells to consumers.

Recall, however, that one of the strong points of the VAT system was that it limited the incentive for fraud at the final-sales-point, the point where the seller and buyer have the greatest incentive to collude in hiding their transaction from the taxman. Moreover, as noted before, about 80% of the VAT is now paid by less than 10% of firms, so enforcement is fairly easy. Under the reverse-charge system, enforcement would have to be at the level of the millions of retail outlets, which consist – especially in some EU nations – of a disproportional number of small and tiny ‘firms’ for whom the record keeping would be a real burden, and fraud a real temptation.

According to the 1995 European Parliament report (VAT fraud has been under study for a very long time), the experience in countries that use sales taxes suggests that fraud is not too great of a problem at the retail level as long as the tax rate is low. Quoting the VAT scholar Alan Tait, the report notes: "At 5%, the incentive to evade tax is probably not worth the penalties of prosecution; at 10%, evasion is more attractive, and at 15-20% becomes extremely attractive." Only Iceland, with a 25% sales tax, has ever attempted the levels attained by VAT.” Since many EU member states have VAT rates above 20%, one has to wonder whether the reverse-charge would not be a pyrrhic victory over tax criminals. Organised crime, after all, has much more efficient decision-making procedures than the EU.

The ‘Origin’ Principle

Another conceivable overhaul of the VAT system is the so-called ‘origin principle.’ This could be called the ‘tax-and-let-tax’ option. Each member state charges the VAT rate desired and runs the system as before with one big exception. There is no de-tax-and-re-tax exercise for goods traded across the EU’s internal borders. As mentioned above, this could lead to a delocation of firms to low VAT rate nations since some of the burden of the VAT – as is true of any consumption tax – is born by firms. Being located in a lower VAT nation would therefore imply a lower tax burden. Plainly, this system would only be politically viable if EU nations could agree to radically narrow their VAT rates. The top allowable rate is currently 25% (imposed by Sweden and Denmark) while the minimum standard rate is 15 (applied by tax havens Luxembourg and Cyprus).
Conceptually, this is like VIVAT with a zero sales tax and a VAT rate that was set independently by each EU member.
Given the current political climate, this option is a non-starter. This is an easy thing to say since it has already been thoroughly rejected. History provides insightful glimpses into the EU’s decision-making quandary when it comes to taxes.

On New Years Day 1993, the tax controls at EU internal borders vanished, so the pre-1993 system – which was based on border checks – had to be reformed. The vanishing checkpoints were foreseen in the 1986 Single European Act, so common sense predicts that the EU would have worked out the new system in a sensible and timely fashion. Common sense and taxation, however, seemed to be strangers already in the 1980s.

Taxation is a politically-charged issue in all member states (i.e. voters actually know and care about tax rates) and EU decision-making in the area requires unanimity, so nothing is done in a timely fashion. As the European Parliament’s 1995 report put it: “The Commission’s original proposals - first outlined in the Single Market White Paper of 1985 - were the subject of inconclusive debate until October 1989, when it was realised that the time was then too short for their implementation by January 1993. Instead, a less ambitious alternative was devised, making possible the ending of frontier tax controls while retaining key features of existing arrangements”. It is this 11th hour system, the transitional system, which is now in effect.

While EU leaders could not agree a good solution in time, they did commit themselves to finding a solution in the future. The original Single Market legislation required that the transitional system be replaced by 1996. The Commission was to submit proposals for a definitive system before the end of 1994, and the Council of Ministers was to reach a decision on it before the end of 1995.

The Commission came up with their proposal on time, but the Council was not impressed. No formal legislative proposals appeared. In lieu, the Commission published its plan for the definitive system. In essence, it proposed an origin-principle system without export rebates within the EU, so that firms would be entirely neutral to selling anywhere in the Single Market. To keep the playing field roughly level, VAT rates would be harmonised within a narrow band and the question of the allocation of VAT revenues would be separated from the VAT system itself. In particular, it would be based on national consumption statistics and national VAT rates. In pursuit of the ‘definitive system,’ the Commission drafted several pieces of legislation that were panned by the Council of Ministers. All these proposals have been withdrawn by the Commission. Plainly, the origin system is a non-starter in the VAT reform race.

Conclusions

The Common Agricultural Policy and the EU VAT system are not usually lumped together, but there are some intriguing parallels. Both systems are so massively complex that an odd combination of experts and crude political calculations dominate the policy debate. Both systems involve a devilish mix of special-interest politics, national political posturing, and a distinct lack of big-picture perspective. Most importantly, the ongoing attempts to fix the VAT system are coming to resemble the long and painful chain of reforms that the EU went through to fix the CAP (a task that is still unfinished). The core of the CAP’s problem was that it raised the EU-wide price of food – thus punishing consumers and foreigners, and encouraging overproduction – when all it really wanted to do was help farmers. After a decades-long chain of reforms that created new problems that lead to new reforms that created their own set of new problems, the EU finally got around to addressing the core problem. It shifted support from prices to farmers. During the decades of dithering, the EU wasted hundreds of billions of euros, created waves of intra-EU imbroglios and infuriated the EU’s trade partners.

The leading contender for VAT reform – the ‘reverse-charge’ system – does not get at the core of the VAT fraud problem; it simply shifts the incentive to fraud to a different point of the value-added chain. Moreover, it does this at the cost of raising the administrative burden on EU firms, especially small retail outlets – just the sort of firms who are the least able to bear the extra burden and most likely to be tempted by the fruit of under-reporting sales. It is not difficult to imagine that the ‘reverse-charge’ reform would lead, in a few years time, to problems that would require a new reform. The chain of reforms to fix the new problems caused by the last reform could go on for decades until the EU finally addressed the core problem.

One of Murphy’s Laws is that every complex system that works is invariably found to have evolved from a simple system that works. While the presentation here is naïve and oversimplified, it would seem that the VIVAT proposal is a simple system that would work.

When EU leaders meet in June to finalise a VAT reform, let us hope that they keep the big picture in mind. After all, that is what common sense says they should do.